THE RELATIONSHIP BETWEEN EXECUTIVE
COMPENSATION AND FIRM PERFORMANCE IN
KENYAN BANKING INDUSTRY
Dr. Josiah Aduda, email@example.com, Lecturer and chairman, department of Finance and Accounting, School of Business, University of Nairobi, Kenya and Leonard Musyoka, University of Nairobi
Economic theory of executive pay has focused on the design of optimal compensation schemes to align the interests of hired managers and shareholders. Agency theory has identified several factors by which these interests may differ; including the level of effort exerted by the manager and problems resulting from the unobservabilty of the agent’s relevant skills. The design of optimal compensation contracts essentially trades-off between different incentive problems and risk-sharing considerations. Research has also been directed to the identification of proper performance standards for evaluation and compensation.
The study sought to examine the relationship between executive compensation and firm performance. The study considered functional form relationship between the level of executive remuneration and accounting performance measures by using a regression model that related pay and performance. The findings of the study suggest that accounting measures of performance are not key considerations in determining executive compensation among the large commercial banks in Kenya and that size is a key criteria in determining executive compensation as it was significantly but negatively related to compensation. The negative correlation suggests the capping of executive compensation to ensure maximization of returns to shareholders.
Keywords: Executive Compensation, Firm performance, Agency theory
1. Background of the Study
The relative importance of various factors used to measure the performance of agents should be related to how well each measure informs the principal about the agent’s actual performance (Banker and Datar, 1989). For decades accounting measures have been used as primary indicators of managerial performance with prior research documenting a significant relationship between accounting based performance and executive compensation (Ittner, et al., 1997). Moreover, both the annual cash bonus based compensation has been linked to accounting based performance as well as numerous other attributes of the firm’s governance structure (Core, et al., 1999).
The compensation literature suggests that most annual cash bonus plans for key executive officers are based in large part on accounting performance measures. There is also some relationship between accounting performance and stock based compensation in many firms since the pool of stock options or stock awards to be distributed each year is often based on annual accounting performance measures. The literature has also documented a high correlation in the total annual inceptive pay amongst the top executives in each firm, and it is commonly assumed that what is observed for the CEO is representative of the incentive pay for the entire top management team for most entities (Gore et al. 2003; Ittner, et al., 1997).
Based on prior work, much of the current executive compensation literature examines the relationship between CEO compensation and accounting based performance. In addition, these studies have documented links between executive pay and other attributes of firms related to their governance structure. These governance related variables have included firm size, number of board members, number of outside directors, number of interlocking directors, whether the CEO is also the Board Chair, and other governance characteristics (Core, et al., 1999). And commonly, accounting based performance measures tend to explain much more of the variance in executive pay across firms and time than do the governance characteristics (Core, et al., 1999). The relative importance of various factors used to measure...
References: Abowd, J. (1990). “Does Performance-Based Managerial Compensation Affect Corporate Performance?” Industrial and Labor Relations Review, 43(3), S52-73.
Abowd, J., and M. Bognanno (1995). “International Differences in Executive and Managerial Compensation,” in R. Freeman, and L. Katz, ed., Differences and Changes in Wage Structures, Chicago: The University of Chicago Press, 67-103.
Aggarwal, Rajesh K.; Andrew A. Samwick (1999). Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence, Journal of Finance, December, v. 54, iss. 6, 1999-2003.
Akhigbe, A., Madura, J., & Ryan, H. (1997). CEO Compensation and Performance of Commercial Banks. Managerial Finance, 23(11), 40-55.
Antle, R. and A. Smith (1986). “An Empirical Investigation of the Relative Performance Evaluation of Corporate Executives,” Journal of Accounting Research, 24(1), 1-39.
Askary, S., Doucouliagos, H. (2005). “Directors’ Remuneation and Performance in the Austrailian Banking Sector,” Working paper, Deakin University School of Accounting, Economics and Finance.
Baker, George P, Jensen, Michael C and Murphy, Kevin J. 1988. ‘Compensation and Incentives: Practice vs. Theory’. Journal of Finance. 43 (3): 593-617.
Baber, W. R.. Janakiranam, S. N., and Kang, S. H. (1996). investment opportunities and the structure of executive compensation. Journal of Accounting and Economics. 21: 297-318.
Barako D. G., Hancock P. and Izan H.Y. (2006). “Relationship between Corporate Governance Attributes and Voluntary Disclosures in Annual Reports: The Kenyan Experience,” Working Paper, Graduate School of Management, University of Western Australia.
Baiman, S. and Verrecchia, R.E. (1995). Earnings and price-based compensation contracts in the presence of discretionary trading and incomplete contracting. Journal of Accounting and Economics 20:93-121.
Banker, R. and Datar, S.M. (1989). Sensitivity, precision, and linear aggregation ofsignals for performance evaluation, Journal of Accounting Research 27: 21-39.
Benito, A. and Conyon, M. (1999). The Governance of Directors’ Pay from UK Companies, Journal of Management and Governance, 3, 117-136.
Berle, A. A. and G. C. Means (1932), The Modern Corporation and Private Property, New York.
Bertrand, M and Mullainathan, S. (2001). Are CEO’s rewarded for luck? The Ones Without Principals Are, Quarterly Journal of Economics, 901-932.
Boschen, J. and Smith, K. (1995). “You Can Pay Me Now and You Can Pay Me Later: The Dynamic Response of Executive Compensation to Firm Performance,” Journal of Business, 68(4), 577-608.
Brown, D. A., Gardner, J., Oswald, A. and Qian, J. (2005) ‘Does Wage Rank Affect Employees’ Wellbeing?’, IZA Discussion Paper No. 1505.
Bushman, R.M. and Indjejikian, R.J. (1993). Accounting income, stock price, and managerial compensation, Journal of Accounting and Economics 16 (Jan/April/July): 349-372.
Conyon, M. J. – Leech, D. (1994): Top Pay, Company Performance and Corporate
Conyon, M. (1997), “Corporate Governance and Executive Compensation.” International Journal of Industrial Organization, 15(4), 493-510.
Conyon M, and Nicolitsas D. (1998). Does the Market for Top Executives Work? CEO pay and Turnover in Small UK Companies, Small Business Economics, 11, 145-154.
Conyon, M and Sadler G. (2001) Executive pay, tournaments and corporate performance in UK firms, International Journal of Management Reviews, 3(2), 141-168.
Conyon, M. (1997), Corporate Governance and Executive Compensation, International Journal of Industrial Organisation, 15, 493-509.
Core, J. and Larcker, D. (1999). Corporate Governance, chief executive officer compensation, and firm performance, Journal of Financial Economics, 51(3), 371-406.
Core, J. R., Larcker, D. 2002. Performance Consequences of Mandatory Increases in
Executive Stock Ownership
Core, J., Guay, W., Larcker, D. (2003). Executive Equity Compensation and Incentives: A Survey. Federal Reserve Bank of New York Economic Policy Review (April), 27-50.
Coughlin, A. and R. Schmidt (1985). “Executive Compensation, Management Turnover, and Firm Performance: An Empirical Investigation,” Journal of Accounting and Economics, 7(1-3), 43-66.
Dale-Olsen H (2006) “Wages, fringe benefits and worker turnover”, Labour Economics, 13, 1: 87-105.
Davidson Consultans (1984): Wage and Salary Administration in a Changing Economy.
Demsetz, Harold, (1995). “Management Compensation and Tournament Theory,” in The Economics of the Business Firm, Cambridge: Cambridge University Press.
Duru, A., Iyengar, R. J. & Thevaranjan, A. (2002). The Shielding of CEO compensation from the effects of strategic expenditures. Contemporary Accounting Research, 19(2), 175-193.
Dutta, S., and S. Reichelstein, (1999). Asset Valuation and Performance Measurement in a Dynamic Agency Setting, Review of Accounting Studies: 11 258-9
Dutta, S., and S
Feltham, G.S., and J. Xie. (1994). Performance measure congruity and diversity in multi-task principal/agent relations. The Accounting Review 69 (July):429-453.
Finkelstein, S. Boyd, B. K. (1998): How Much Does the CEO Matter? The Role of Managerial Discretion in the Setting of CEO Compensation. Academy of Management Journal, 41, pp. 179-199.
Fosberg, R. H. (1999). Leadership structure and CEO compensation. American Business Review, 17(1), 50-56.
Garen, J. (1994). Executive Compensation and Principal-Agent Theory, Journal of Political Economy, vol 102 (6), 1175-1199.
Gibbons, R., and Murphy K. J. (1990). Relative performance evaluation for Chief Executive Officers, Industrial and Labour Relations Review, Vol. 43 (3), 30-51.
Girma, S, Thompson, S and Wright P (2003). Corporate Governance Reforms and Executive Compensation Determination: Evidence from the UK, Royal Economic Society, University of Warwick.
Gore, A., S. Matsunaga and Yeung. E. (2003). Does the Financial Expertise of Monitors Matter? Evidence from the Cash Compensation of Chief Financial Officers. Working paper, University of Oregon.
Hall B and Liebman, J. (1998). Are CEO’s really paid like Bureaucrats? The Quarterly Journal of Economics, 113 (30), 653-691.
Hebner, K. and Kato, T. (1997). “Insider Trading and Executive Compensation: Evidence from the US and Japan,” International Review of Economics and
Finance, 6(3), 223-37.
Hermalin, B.E., and Wallace J. N. (1996), “Firm Performance and executive Compensation in the Savings and Loan Industry,” mimeo, Walter A. Has School of Business, University of California at Berkeley.
Himmelberg, C., Hubbard, G., Palia, D. (1999). Understanding the determinants of managerial ownership and the link between ownership and performance. Journal of Financial Economics 53, 353-384.
Ittner, C.D,. (1997). The Choice of Performance Measures in Annual Bonus Contracts. The Accounting Review 72: 231-255.
Izan, H. Y., Sidhu, B., and Taylor, S. (1998). Does CEO pay reflect performance. Journal of Corporate Governance, 6: 39-47.
Please join StudyMode to read the full document